Reprinted courtesy of the National Post
by Tom Bradley

You're getting ready to retire. For decades, you've been making contributions to your RRSP and TFSA with the purpose of building up a nest egg. Growth was the priority. Now, it's time to shift gears. You'll be drawing an income from your investments, so the focus will be on capital preservation and income.

But wait. Being a retired investor is even harder than that. You're hoping to live another 30 years, so you've also got to protect against inflation, and maybe even grow your capital. What is the priority? A steady flow of income or higher long-term returns?

For most retired investors, the answer is simple. It's all about yield. Holding bonds and structured products that have attractive payouts, and dividend stocks like banks, utilities and REITS.

But in my view, this unquenchable thirst for yield can go too far, resulting in undiversified portfolios and a lower total return (interest, dividends and price appreciation). I'm going to focus on the return aspect here because I see too many instances where people have chosen (or been sold) products that clearly sacrifice their long-term returns for the sake of a higher yield.

There's a great example of this in the ETF arena. BMO offers two almost identical ETFs – the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) and BMO Covered Call Canadian Banks ETF (ZWB). ZEB is super simple. It holds six Canadian banks in roughly equal proportions. ZWB owns the six banks, but also writes call options against them to generate a higher payout. Its yield is currently 5.2 per cent compared to 3.3 per cent for ZEB.

The extra yield sounds great, but there's a hitch. Over the five years ending Aug. 31, the covered call ZWB had an annualized return of 11.3 per cent (including distributions and price gains). Impressive, but the uncovered ZEB earned 13.2 per cent. Now, five years is a relatively short period and it doesn't include a bear market, when covered calls may lessen the downside, but it shows how a focus on current income can be detrimental to wealth generation.

BMO also has 'twin' ETFs that invest in utilities and the Dow Jones Industrial Average. They show the same pattern. The covered call versions offer higher yields but have produced lower returns. I'm not privy to the specific reasons for the shortfall, but I do know that there's no free lunch in the options market. It's dominated by sophisticated players who have yet to find a new, magical source of return. The reality is, in exchange for the premiums received for selling call options, there's a give up – the stocks' price appreciation is cut short.

For retirees, the hardest part of investing is generating a reasonable return with limited downside. Extracting income from a portfolio is the easy part. And yet, products designed to feature income, with elegant strategies like covered call writing and T-series funds that return capital tax-free, abound. It's revealing that in the case of BMO's twins, the covered call ETFs are all larger than the straight-ahead versions. But that's not where your focus should be. You're looking for more balance between your short and long-term needs.

On the investment side, that means holding a broadly diversified portfolio that has exposure to different types of securities from a range of geographies and industries. The asset mix should fit with your goals and risk tolerance. If you have a strong affinity to yield, your portfolio can be tilted toward higher yielding securities, but do so judiciously. Don't go overboard.

As for income, start by setting up your accounts so you're receiving cash from everything you're being taxed on. That means taking interest, dividends, fund distributions and RRIF payments in cash, rather than having them reinvested. If that's not enough to support your lifestyle, then set up an automatic monthly withdrawal to provide a top up.

Investing is all about tradeoffs. Risk versus reward. Short-term versus long. Your best interests versus your advisor's. When it comes to your portfolio, it's total return that counts, not just yield. Earning 5 per cent per year with irregular payments of 2 to 3 per cent is better than earning 3 per cent with a smooth, monthly income of 5 per cent.